SEC’s revised view of antifraud law survives State Street appeal

Former State Street chief investment officer John Flannery was the unfortunate victim of the Securities and Exchange Commission’s decision to broaden the scope of liability under antifraud provisions of the Securities Act of 1933 and the Securities and Exchange Act of 1934.

As the 1st U.S. Circuit Court of Appeals recounted in an opinion Tuesday that exonerated Flannery and his former State Street colleague James Hopkins, an SEC administrative law judge found the men weren’t liable for misleading investors about State Street’s holding. But SEC commissioners, in a 3-2 ruling, said they were. The commissioners used their order in the State Street case to clarify the SEC’s definition of who “makes” statements to investors, in light of uncertainty from the U.S. Supreme Court’s 2011 ruling in Janus Capital v. First Derivative Traders. And under the new rules, the SEC said, Flannery had run afoul of the Securities Act by engaging in a deceptive “course of business.”

The 1st Circuit said he had not. Neither Flannery nor Hopkins, according to the appeals court, misled State Street clients. The appellate opinion stuck closely to the facts of each man’s case to conclude that the SEC flat out hadn’t shown Flannery and Hopkins committed fraud. The 1st Circuit panel, Judges Sandra Lynch, Norman Stahl, and William Kayatta, said in an opinion by Judge Lynch that the commission “failed to identify a single witness that supports a finding of materiality” against Flannery. “There is not substantial evidence to support the commission’s finding that Flannery engaged in a fraudulent ‘practice’ or ‘course of business,'” the appeals court said.

Flannery’s lead lawyer, Mark Pearlstein of McDermott Will & Emery, said the 1st Circuit’s fact-based finding was, for his client, “the most satisfying way to win.” It’s hard to argue with that. Flannery has maintained for five years that the intention of two State Street letters to clients in August 2007 was to highlight investment risk, not to minimize it. The 1st Circuit agreed the SEC misread the first letter.

But because the appeals court based its exoneration of Flannery only on the evidence in his case, it did not reach broader questions of consequence for future SEC defendants.

As I’ve explained, the commission’s reinterpretation of antifraud law in the Hopkins and Flannery opinion was quite controversial among securities lawyers. The SEC commissioners said, for instance, that the Supreme Court’s restrictive definition of who makes statements to investors does not apply in cases alleging violations of the Securities Act. It also said the SEC could bring “scheme liability” actions under the Securities and Exchange Act against defendants who didn’t technically make statements. Former SEC chief litigation counsel Matthew Martens, now a partner at Wilmer Cutler Pickering Hale & Dorr, called the SEC opinion’s implications “potentially staggering” in an analysis for the Bloomberg BNA Securities Regulation report.

Flannery’s brief to the 1st Circuit challenged both the substance of the SEC’s revised interpretation of the Securities Act and the commission’s authority to change the rules partway through his case. (Hopkins, who is represented by Mintz Levin Cohn Ferris Glovsky & Popeo, did not; the SEC’s liability finding against him was not based on reinterpreted rules.) The U.S. Chamber of Commerce joined the challenge with an amicus brief arguing that the SEC is not entitled to deference in remaking the rules for hybrid civil and criminal statutes. The SEC responded that its interpretation was the only reasonable reading of the law and that it is entitled to clarify its view of the law via enforcement opinions.

The 1st Circuit opinion did not resolve any of these issues. The panel explicitly said that because it concluded Flannery did not deceive clients, it did not need to reach a decision about the SEC’s interpretation of what constitutes a fraudulent course of business under the Securities Act. The opinion entirely avoided the question of the SEC’s mid-case rulemaking.

As a technical matter, the 1st Circuit vacated the SEC’s Flannery and Hopkins order, which voids the order’s legal analysis along with its conclusions about the State Street executives’ liability. But effectively, the 1st Circuit has left in place – at least for now – the legal interpretations the SEC articulated in the Flannery and Hopkins opinion. Flannery counsel Pearlstein said the commission has cited elements of the opinion’s legal analysis in subsequent enforcement actions. So it will be up to future defendants to push challenges to the SEC’s broadening of the scope of liability through federal courts and administrative proceedings.

I emailed the SEC to confirm the appellate court opinion does not affect its legal interpretation and to ask whether it intends to request additional review of the State Street case. An SEC spokesman declined to comment.

(This post has been updated to clarify that the 1st Circuit vacated the entire SEC order in the State Street case.)